December 16, 2015
The staff of CalPERS, the $288 billion California public employees’ pension fund, has had a bad couple of weeks. Just before Thanksgiving, they released long-awaited figures showing that over the 25 years since 1990, the pension fund paid more than $3.4 billion in performance fees to private equity firms — so-called carried interest that is taxed at the lower capital gains tax rate rather than as ordinary income. Private equity has persuaded public pension funds that these performance fees are warranted by the exceptional returns earned on PE investments, but the evidence is weak. Because PE investments are illiquid and risky, returns need to be high enough to be worth the risk. CalPERS’ benchmark is a stock market index of domestic and global stocks plus 3 percent, the typical private equity risk premium. Unfortunately, CalPERS’ PE investments failed to beat this benchmark in the past three-year, five-year and ten-year time frames. Indeed, over the 10-year period, CalPERS would have had the same returns by investing in the stock market index in its own benchmark without the added risk of investing in private equity.
CalPERS staff glossed over this record of mediocre performance when it released the data on the huge performance fees it had paid. To the relief of the industry, it reported stellar returns from its investments. It managed this feat by reporting its returns from its private equity investments without any adjustment for risk, despite the fact that CalPERS’ Private Equity Program Policy requires the pension fund to aim to maximize its risk-adjusted returns. It also compared its PE returns with the poor returns from its actual investments in the stock market. The poor performance of Its actual stock market portfolio made its PE investments look good by comparison.
Reporting absolute returns from private equity investments rather than risk-adjusted returns lets both the CalPERS’ staff responsible for managing these investments and the PE firms off the hook if PE investments underperform the benchmark.
Remarkably, on Monday a committee of the CalPERS’ board was asked to vote on a staff proposal to eliminate from its strategic objective the requirement that returns from its private equity investments should be high enough to outweigh the risks of these investments. Instead, the objective would simply be to enhance the pension fund’s returns. The change was described by CalPERS’ staff as part of its effort “to eliminate vague and untestable language” from its various benchmarks.
If adopted, this would be a major change in CalPERS private equity policy. It could facilitate continued investments in private equity without regard to the risks implicit in these investments or to whether the PE firms had earned their performance fees by delivering outstanding performance.
My colleague and co-author, Rosemary Batt, and I were concerned that striking the goal of maximizing risk-adjusted returns from the PE policy’s strategic objective on Monday could be followed next year, as part of the staff’s review of all of its investment benchmarks, by the elimination of any risk adjustment in the PE benchmark. With the help of Alan Barber, CEPR’s Domestic Communications Director, we placed an op-ed in the Sacramento Bee, which ran on Monday morning. Our understanding is that the op-ed was made available to CalPERS’ board members just prior to the vote. CalPERS’ staff argued that the vote on Monday would not eliminate its private equity benchmark. But they left open the possibility that it would be altered in the 2016 review of investment benchmarks.
In a voice vote, the CalPERS board committee defeated the proposal to strip out language in the strategic objective that required a risk-adjusted benchmark for PE investments. PE firms will continue to be expected to provide better returns than the stock market and beat this benchmark. This is an important victory for the 1.7 million employees and retirees that depend on the pension fund to manage their retirement savings and want to know that these savings are wisely invested.